Your Credit Score and the New Credit Card Rules

After new credit card rules took effect in February, cardholders found that it wasn't all good news. Card companies hit them with new fees and interest rate hikes, as the companies tried to replace sources of revenue that reform was quickly cutting off.

Millions of Citibank cardholders, for example, got hit with a $60 annual fee on cards that were previously free. That's got some of my readers asking whether cancelling these cards will hurt their credit scores. And, if so, will it hurt enough to matter?

The first answer is "yes." The second one isn't so easy.

Your credit score is an algorithm aimed at handicapping your propensity to pay your bills. It looks at a number of factors that Fair Isaac Corp., the creators of FICO scores, think best indicate whether you're both responsible and solvent.

Little missteps -- like having too few credit cards; or cards that are too close to their limits -- can undermine your score. But your FICO score is like an ever-changing fingerprint. Every time someone reports another piece of information about you, your score can change. How much it will change will vary dramatically based on what else is in your file.

To better understand why, you need a little backgrounder on how these scores work.

There are five broad categories that make up your FICO score -- the most widely used of the nation's credit scoring models. The most important factor is your payment history, which reflects whether you pay your bills on time, have ever filed for bankruptcy, faced foreclosure, or settled debts for less than 100 cents on the dollar. Your payment history accounts for 35% of your score and would not be affected by closing an account.

But the second and third most important categories determining your score -- "amounts owed" and "length of credit history" -- could be affected by closing a credit account, particularly if it was your oldest card. These two categories account for 45% of your overall score. That doesn't mean your score would be savaged by closing an account, but it could be.

Here's why.

FICO's "amounts owed" category, accounts for 30% of your score. It looks at five different things:

diversity of credit: Do you have student loans, home loans, car loans and credit card loans? The more types of credit you have, the better it is for your credit score.

number and types of accounts with balances: Having balances on some accounts is good; having a balance on every account is bad.

how much you owe vs. how much you owed: If you borrowed $500,000 to buy a house, but now only owe $300,000, you've likely demonstrated the ability to responsibly pay down debt. If on the other hand, the most you've borrowed is $10,000 and you owe $9,900, you have a way to go before proving you can whittle down your debts.

amount owed versus debt available: If you have 10 credit cards with $10,000 limits, you have $100,000 in credit available. If you have a balance of $2,000 divided among 2 or 3 of those cards, you are using just 2% of your available credit--which is great for your score. But, if you are using almost all your available credit, your score dives.

If you cancel a card that has a high credit limit, the "amounts owed vs. debt available" portion of your score could drop because your debt-to-available-credit ratio could rise. If this was your only credit card, it might also affect the diversity of your credit, further harming your credit score. But it will have a much bigger impact if you have few forms of credit and a short history of paying down debts than it will if you've got lots of different types of loans and plenty of positive information in your file.

Another 15% of your credit score is based on the "length of credit history."

FICO looks at the age of your oldest account; the age of your newest account and the average age of all your accounts. So, if you close the account that you first opened in 1983 when you graduated from college and your next oldest account was opened in 2003, you'd lose 20 years of credit history, and reduce the "average age" of your accounts, by dumping that card.

That said, the same action can impact different consumers' credit scores in vastly disparate ways.

That's because these small changes have a big impact on someone with a "thin" file--few forms of credit and a short history, said Liz Pulliam Weston, author of "Your Credit Score." But they have little affect on those who have a weighty credit file, where they've used lots of different types of credit responsibly for long stretches of time.

That means a person with lots of history can cancel that now-costly Citibank card at will. But somebody who has a thin file might want to think twice.

"I really hate the idea that issuers might use people's fear of hurting their credit score to get them to accept fees that they don't want to pay," said Weston. "If you have good scores and plenty of other credit, go ahead and close the darn account."

If not, you should consider taking a look at how you use your cards.

It helps to know that credit card companies make money on you in two ways: If you carry a balance, you pay interest. But even if you never carry a balance, the card company makes money when you use the card to charge things. That's because they charge "interchange" fees to retailers who take the cards. If you charge a lot, you can be a profitable customer for the bank. Better yet, when you pay off your balance every month, you're a profitable customer without posing any credit risk to the bank.

The bottom line: If you're willing to use this card for most of your charges, they're more likely to waive your fee. In fact, Citibank says that anyone who charges $2,400 annually -- that's an average of $200 a month -- will get the annual fee refunded.

So if you need the card for charges, or for the purposes of keeping your credit score lofty, it doesn't take too much to keep it fee-free. You just have to use the card. But be sure to pay off the balance every month. If you don't, you'll pay a lot more in interest charges than you'd save by avoiding the fee.